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Volatility and Markets

Since the 1970s we have seen more market integration and correspondingly an increase in risks. This is partially because one shock often reverberates across markets. This has been shown repeatedly as one event causes changes across the board. For example: the 1973 oil embargo lead to higher interest rates and inflation. In 1994 the Mexican peso and Mexican stock market collapse. This spread quickly across borders and threw the economies of many Latin American countries into turmoil and recession.

These interest rate risks, foreign currency volatility, and commodity risk increases have led to a new demand for tools to reduce risk. These include derivatives as well as risk shifting that can reduce the overall risk. In order to understand this, we will first look briefly at the various markets and how the typical investor is involved.

Stocks

Stocks are equity securities (They are the residual claimants). If you buy a stock you are buying the right to the cash flows that are left over after all other stakeholders are paid.

Markets
In the US stocks traditionally have sold on the both exchanges and over the counter. An exchange is a central location where buyers and sellers come together to trade. Many cities used to have their own exchanges the largest of these was and still is the NYSE. Many of the other exchanges have fallen by the wayside but there are still several “regional” exchanges including the Philadelphia Stock Exchange, the Chicago Stock Exchange, the Boston Stock Exhange, and the Pacific Stock Exchange, .

The American Stock Exchange is the second most widely known exchange. It is known as the curb market since it began trading at the corner of Wall and Hanover Streets in NY city in 1849. It moved into a five-story building in 1921 and its ticker service became famous for its ability to transmit 300 characters per minute. In 1998 the merger between the NASD and the Amex is completed (data from Nasdaq-Amex Backgrounder).

The Nasdaq is the most famous and largest of the over-the-counter markets. From its beginnings in 1971 as a small network between dealers, it has evolved into a nationwide computer network able to handle billions of shares per day. It has been a major success--partially as a result of its technology orientation and partially as a result the technology companies that are listed on the Nasdaq.

                                     Nasdaq                                                 AMEX
Number of companies     5000+                                                 approx 800
1998 year end cap     $2.6 Trillion (+ 44.4% since 1997)             $149.7 Billion (-7.7% since 1997
1998 IPOs                         273                                                     21
Total Share Volume         202 Billion                                             7.3 billion
Dollar volume (yearly)     $5.8 Trillion                                            $288 billion
                                                              ( Source 1998 Nasdaq-Amex Backgrounder)

The NASD also has markets on the horizon for both Europe and Japan. In October 1999 they announced plans to launch an Internet based market in Japan. This idea would eventually be copied here as well.

In addition to these markets there are many other newer markets. These are small in size and are almost exclusively computerized networks but are playing a growing role in after-hour trading as well as institutional trading. These include Instinet, the Arizona Exchange and others.

Instinet is the largest and most widely used of these “small” markets. It was founded in 1969 and takes no position other than to bring together buyers and sellers. Until recently (September 1999) Instinet was available only to large institutional investors. Now however it is available to smaller investors as well.

The key advantage to these newer smaller markets is the longer hours of trading available to the investor. Larger institutional traders may get a better price (lower transaction costs) but generally speaking the key is the liquidity and the ability to trade after the markets close.

In face of this increased competition the major markets are planning on extending their own trading hours.
Not to be left without a competivie advantage, Instinet recently announced its plans begin trading fixed income securities.

Stock Indices
There are many ways to measure how the “market “ is doing. The most popular in the US are the Dow Jones Industrial Average and the S&P 500

There are many differences between the two indices--most notably, the number of firms. The Dow has only 30 firms whereas the SP 500 has 500 firms. Additionally the Dow is made up of exclusively of stocks that trade on the NYSE. A major difference in the two is how they are calculated. The Dow is a price weight index. For information on these indices and how they are calculated, click here.

Fixed Income markets
Bonds: corporates and Treasuries, Munis, Strips, CMOs
Preferred stock

Mortgage-backed securities

In the face of rising risks, S&L’s and even many banks were too expensive and inefficient. Needed a way top drive down costs and risks.

This led to the selling of mortgages, and later all types of loans through secutization, Why sell loans? The are interest sensitive which hurts the banks position. However it is infeasible to sell each loan individually. Why? Too small and too high of transactions costs. In the early-mid 1980s (with the advent of computer technology) came the idea of bundling these loans and selling them off. And hence was an early Financial Engineering success.

Benefits: Lower interest rates, less money tied up for the banks, less interest rate exposure, and more uniform interest rates across banks and across regions of the country
Disadvantages: Few. Degree of standardization may prevent certain loans from being made. This standardization is necessary to create a secondary market, but cn have a down side.

Terms :
Collaterialized Mortgage Obligation
Securitization
Strips
GNMA

Mutual Funds: Major Major success.
A mutual fund is a fund created where investors pool their money and invest all at once. The advantages of this is that small investors can diversify more readily and do not have to incur the high transaction costs often associated with small purchases.
Main ways of breaking down mutual funds are by what they invest in, fees, and where you can buy or sell the funds.